My Diary 328 --- Business Fed & Academic Fed, Black Day & Bright

 

My Diary 328 --- Business Fed & Academic Fed, Black Day & Bright Future, Bond King & Bank of England, Currency on Fire & Oil on the Boiler

September 13, 2007

Talking to investors in these days, my general feeling is that market is trying to look for a direction in a wood of “financial markets which are considerably more global now than a decade ago. 

 

Interestingly, many challenges also emerged to make the “messy” stuff looks more “muddy”, including a long list of Primer Abe’s resignation, Indonesia’s earthquakes, Alcoa and Warren Buffet’s sales of Chinese stocks, the near-peak WTI crude price and an all-time low US/Euro, along with a “never-ever-slowing-down” Chinese economy. Tonight, more fun will once again come from US in the form of weekly claims and tomorrow we will see retail sales. Given the emphasis that Fed speakers have put on “the consumer”, the retail sales umber is critical for Mr. Ben…. There are a lot of things to be fitted into this notes, let me have a try !!

The “Business” Fed & The “Academic” Fed

The Fed is in a dilemma now as it can’t be seen as tolerating complacency by being ready to bail out banks, while at the same time, they can’t afford to sit back and do nothing while a systemic contagion takes place. In more plain words, cutting interest rates isn’t the most appropriate solution to the credit problem because that will simply create new bubbles down the road.

An interesting article from Bloomberg highlights the different approaches adopted by the former chief, Alan Greenspan who trusted his instincts vs. Mr. Bernanke who trusts the MAQS. The writer based the distinction between Bernanke and Greenspan on their different resumes and competing views about managing risk and uncertainty…“Greenspan was a business economist before he became Fed chairman in 1987 and he read the economy like an income statement. His decisions were often based on close readings of disparate data, and his methods defied quantification”…”Bernanke, a former economics department head at Princeton University, has spent most of his career in academia. His analysis is based on models by assigning more confidence in forecasts and statistical methods, high-frequency indicators and simulation exercises. “ 

To me, this is somewhat a difference between a “business” man and an “academic” professor. But I think they have one thing the same --- that is both approaches have risks!!! I basically agree with what Greenspan said in his August 2003 speech --- uncertainty is the defining characteristic of the monetary policy landscape, while only a limited number of risks can be quantified with any confidence.

Put it short -- risk is quantifiable, uncertainty is random.  I think this is the root reason causing the substantial loss of Goldman Sachs’ Global Alpha hedge fund which fell 22.5% in August and 44% from its March 2006 peak. In an unsigned report today, Goldman defends itself by saying that … “we still hold our fundamental investment beliefs that sound economic investment principles coupled with a disciplined quantitative approach can provide strong uncorrelated returns over time''. Aha, sound strong but I think they missed one critical point --- in a panic world with uncertainty, the assets’ correlations usually rush to one……I believe Mr. Carhart and Iwanowski know it well, but not the black-box models.

 

A Black Day & A “Bright” Future

Today is a “black” day for A-shares as coals and steels are the “black” forces which drive the CSI300 index up 2.83%, to 5349.97. In numerical term, 80% of the stocks advanced but trading volume was slightly lower. One thing deserved to be think about today is that many of  those steel name which reached 10% limit are  smaller steel enterprise …Does this the trend imply further sector consolidation?

In Hong Kong, HSI (+.93%) and HSCEI (+1.3%) are basically flat as market seems losing its enthusiasm. HK Stock Express got new information saying that the “train” will start after the National Day golden week. I doubt it will be so fast actually … it is more like a small dose of “Dope” trying to move H shares. However, one thing worth for notice is that the 1^st QDII fund --Southern Global Selection Fund, raised RMB50 billion within one day…Really, it is 50 billion in one day + BoJ &CCB IPOs…liquidity is still abundant.

I think it is time to have an outlook for the A/H stock markets, before Fed and PBOC’s moves. China’s macro environment continued to remain robust witnessed by recent yoy data such as Trade surplus (+67.1%), Retail sales (+17.1%), Industrial output (+17.5%) and Money supply (M2 +18.1%). In light of the persistently high economic growth and surge in inflation, the Chinese government is expected to introduce more tightening measures, but it is highly unlikely that the government will allow them to generate excess economic weakness. I believe that the Chinese government will remain supportive and continue to maintain its long standing pro growth policy.

Going forward, we will continue to see the impact of Chinese liquidity spilling over to HK along with more deregulation expected, which will lend good support to asset prices. However, one side effect of Chinese money is a potentially near-term overbought situation as PE ratios are becoming less attractive as it is approaching its long-term average.  However, on a positive note, the long-term fundamentals remain to be solid, buoyed by the positive earnings upgrades.  ROE is at record level, with solid increases in asset turnover and falling financing costs, implying the rise of ROEs in A/H is a result of structural improvement than cyclical in nature.  Thus, what I try to say is that the outlook continues to be bright (Qian Tu Shi Guang Ming De)!  But you must be a long-term investor at first.

The Bond King & The Bank of England

Bill Gross, the world's Bond King sold the remaining holdings of his Total Return Fund’s commercial paper last month as demand for short-term corporate debt dried up. In April, The $104 billion Pimco TRF had 20% of its assets in debt carrying the highest CP ratings.

In addition, last night Governor King reiterated that the BOE’s focus is on O/N borrowing rates, instead of aiming at bringing down market rates at longer maturities. In taking this ground, the BOE is aligned with the Bank of Canada, which also has limited its liquidity injections to the overnight market, while different from the Fed and the ECB, each of which has engaged in term lending and broadened their definitions of acceptable collateral. Not surprisingly, 3M LIBOR in Pounds and CD$ has exceeded that in euros and US$.

Once again, I think it is time to review headline risks which could be talked again over the remainder of 2007: 1) the liquidity crunch in the money market has hit the banking system, dramatically shifting the S&D equation for ST funding.  A significant amount of CP has been refunded through other mechanisms (mainly bank balance sheets) but will need to return to the market at some point; 2) the consequent rise in BBSW/LIBOR is effectively starting to look like a de-facto tightening in monetary policy.  Given this is the key rate that banks fund themselves, I expect to see this hit loan rates; 3) Fixed and FRN refinancing remains a key issue over the next few months. I expect that we will still see supply coming at wide spreads in order to clear deals. 

Overall, data in the US is starting to capture the impact of the events of the last few months. I will watch for further signs of labour market weakness, poor housing conditions, retail sales etc to signal potentially weaker growth and earnings into '08. Perhaps most importantly, the market needs clarity on the global credit environment and whether the liquidity squeezes and sub-prime ripples have further to play out.

Currency on Fire & Oil on the Boiler

Today, both Yuan and Euro make all-time high. China's Yuan rose to the highest since the dollar-link was abandoned more than 2yr ago. Some traders are speculating the PBOC wants a stronger currency to help slow the world's fastest-growing major economy.

The USD index continues to weaken as IR spreads narrow in anticipation of Fed’s interest rate cuts. Based on option pricing, the market currently sees a 53.2% chance of a 50bp cut at the 18th Sep, FOMC meeting and a 36.4% chance of a 25bp cut. This compares with 38.0% and 31.5% respectively last week. Clearly, were the Fed to keep rates on hold… that would be a major shock to the market … Sounds like Fed is hostaged by the markets, doesn’t it?

Some street researchers have done much historical analysis on the USD &Fed Cut back to the beginning of the 1990s and conclude that in all but one cycle - after 9/11 and the NASDAQ crash where neither the speed nor the extent of Fed easing was easily predictable - the USD has rallied as the Fed has cut rates. This implies to me that USD is expected to recover in early 1H2008 as interest rate spreads should give way to relative growth prospects.

Quickly talking about Oil, the “black gold’s” prices shot higher in response to that US oil inventories plunged 7 million barrels last week. The price of WTI crude for October delivery topped $79.90/bbl.  The unexpected surge in oil prices places an additional burden on US consumers that already are weighed down by tighter credit market conditions, stable to falling house prices, and the possibility of a slowdown in labor income growth via a weakening job market … Now I believe we all you can see the dilemma facing by Dr. Bernanke and his Fed colleagues.

Good night, my dear friends